New data analysis reveals that private real assets offer compelling potential for institutional investors to enhance risk-adjusted returns as they anticipate more frequent volatility spikes and uncertainty regarding the pace of economic recovery, inflation, and interest rates.
According to the analysis, private investments in relatively illiquid categories of real assets – farmland, timberland, and commercial real estate – have exhibited low or negative correlations to stocks and bonds, diversifying portfolio risk. In the analysis, adding private exposure to any one of those categories increased portfolio returns and reduced risk, resulting in higher Sharpe Ratios.
The analysis was conducted by Gwen Busby, Ph.D., Head of Economic Research and Strategic Development, GreenWood Resources; Skye Macpherson, CAIA, Head of Portfolio Management, Westchester Group Investment Manager; and Abigail Dean, Global Head of Strategic Insights, Nuveen Real Estate.
Four key observations
In addition to the lack of correlation with traditional assets, the authors of the analysis chose farmland, timberland, and commercial real estate, because they are relatively illiquid, infrequently traded, or insulated from commodities speculation, such as options trading. In addition, farmland, timberland, and commercial real estate have at least 25 years of index performance data as a reasonable foundation for analysis.
The analysis used traditional mean-variance portfolio optimization (MVO), based on historical performance, standard deviation, and correlations of returns by asset class. In conducting the analysis, four key observations emerged.
Observation #1: Real assets improved the risk-adjusted returns of a portfolio of traditional stocks and bonds.
Institutional investors want to know how private real assets impact the risk and return attributes of a portfolio of stocks and bonds. In the data below (see Fig. 1), efficient frontier charts show the impact of adding farmland, timberland, and real estate individually to a stock/bond portfolio. The table also shows the impact of combining all three categories. In this example, real assets were constrained to 15%, divided evenly at 5% in each.
Results of analysis
- Each category of real assets increased returns, with similar or lower levels of risk, resulting in higher Sharpe Ratios.
- Farmland had the greatest impact on risk-adjusted returns and received the largest allocation in an unconstrained portfolio at 42%. Real estate at 29% had the second biggest impact on returns, followed by timberland at 21%.
- Diversifying a stock/bond portfolio with a 5% allocation to each of the three real assets increased annual returns by 28 basis points and reduced risk by 67 basis points, producing a higher Sharpe Ratio.
Several factors account for farmland’s record of higher and uncorrelated returns and lower risk, despite its being the least liquid of the three categories. The fact that most transactions occur between individual farmers and do not include institutional investors helps reduce volatility. Holding periods that generally last 20 years or longer also contribute to low volatility. Other reasons for farmland’s record include population growth, a growing middle class, productivity gains, increased demand for alternative fuels, and supportive government policies.
Overall, results support the case for diversifying traditional portfolios with multiple categories of real assets even when constrained within realistic limits. The constraints reflect supply limitations, the relative illiquidity of real assets, their relatively high transaction costs, and the limited history contained in the analysis.
Observation#2: Private real assets provided higher returns with lower volatility than publicly traded commodities and real estate stocks.
Private real assets were compared with publicly traded commodity stocks and commercial REITs to assess diversification benefits against the illiquidity of private assets. Since many institutional investors already have exposure to REITs and commodities, such as metals or oil and gas, the impact of combining private real assets with public stocks was also compared. The analysis used fixed allocations and constrained alternatives to 15% of the portfolio, consistent with realistic limits.
The data below compares three portfolios consisting of a fixed 85% in stocks and bonds in a 60/40 ratio, and 15% in alternative assets. Portfolio 1 adds three categories of private real assets, divided evenly at 5% each. Portfolio 2 adds three categories of publicly traded commodities and REITs, divided evenly at 5% each. Portfolio 3 combines private and public assets, split evenly at 2.5% each.
Results of analysis
- Private real assets increased portfolio returns and reduced volatility, resulting in a higher Sharpe Ratio, versus publicly traded commodity stocks and REITs. This can be seen by comparing the performance of Portfolio 1 and Portfolio 2 in Fig. 2 (above).
- Private real assets helped to diversify the volatility risk of publicly traded commodities and REITs. This can be seen by comparing the performance of Portfolio 2 and Portfolio 3 in the above charts. The combination of private and public assets in Portfolio 3 increased returns by 22 basis points and reduced volatility by 73 basis points, resulting in a higher Sharpe Ratio, compared to Portfolio 2.
Observation #3: Farmland dominated a portfolio consisting only of private real assets.
The next analysis shows how different asset categories work together in a portfolio consisting only of private real assets by examining how the structure can change based on different investment objectives. An efficient frontier using farmland, timberland, and real estate allowed comparison of three portfolios producing the highest efficiency, lowest risk, and highest return (see Fig. 3).
Results of analysis
- The most risk-efficient portfolio was dominated by farmland at 64%, but also included 19% timberland and 17% real estate, benefitting from low correlations among the categories.
- The lowest-risk portfolio reduced farmland exposure to 39% and increased timberland and real estate to 25% and 36%, respectively, reflecting relatively low or negative correlations between categories.
- The highest-return portfolio consisted of 100% farmland, reflecting higher returns and lower volatility compared to timberland and real estate.
- Overall, the most efficient real asset portfolio generated much higher risk-adjusted returns than the most efficient combination of traditional stocks and bonds. The real asset portfolio produced an additional 377 basis points of return and only increased standard deviation by 163 basis points.
Observation #4: Constraining real assets within practical limits still improved performance.
How much real assets exposure is reasonable for institutional investors? Real assets are expected to continue their recent steady growth, with current portfolio allocations generally estimated at 5% to 10%, and endowments ranging up to about 15%. Overall, real assets represent more than $10 trillion out of $27 trillion of global institutional assets under management in 2019, or nearly a third. Additionally, institutions are increasing their exposure to alternatives in efforts to increase current income and risk-adjusted returns, dampen volatility, and meet specific needs, such as inflation protection.
Mean-variance optimization outputs may suggest extreme allocations to individual asset classes based on returns for the time period used as inputs. For most institutions, allocations exceeding 25% to individual real assets categories would be unrealistic. Most portfolios would lack sufficient liquidity to meet near-term spending obligations, and investors would have difficulty accessing enough farmland and timberland. Moreover, questions about the limitations and relatively short history of index data would argue against such large holdings in real assets.
There is no single optimal allocation to real assets, which will differ based on the investor’s specific risk profile. The next analysis considers two model portfolios representing a conservative allocation of 20% stock and 80% bonds and an aggressive allocation of 80% stock and 20% bonds. The combined real asset allocation is limited to 10% (3.3% per category) in the conservative portfolio and 20% (6.6% per category) in the aggressive portfolio.
Results of analysis
- Despite the allocation limits, real assets reduced volatility compared to only stock-bond portfolios – resulting in higher risk-adjusted returns (see Fig. 4, above).
- Overall, results show that, based on historical performance, investors could improve portfolio risk-adjusted returns with allocations that were fractions of the unconstrained allocations, but realistic for institutional investors.
The results of the overall analysis of private real assets conducted by Busby, Macpherson, and Dean should be considered broadly illustrative – not specific investment recommendations. As noted previously, data limitations – relatively short time series, self-reporting, and a “smoothing” effect from periodic appraisals – are likely to understate actual volatility of private real assets returns. Traditional mean-variance optimization has well-known drawbacks that are not tied to a specific asset class, including the assumption that returns are normally distributed and reliance on historical returns that cannot predict future results. While these limitations are important to acknowledge, they do not undermine the potential for real assets benefits to persist in the future. First, long-term capital appreciation depends on inexorable global trends –population growth and urbanization – that drive steadily rising demand and diminishing supplies of food, wood products and high-quality commercial real estate. Second, real assets’ low correlations and capacity to diversify risk are primarily a function of their being private, relatively illiquid, and not subject to public markets and speculative trading.
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